On 8 December 1996, Thomas L. Friedman published his Golden Arches
Theory of Conflict Prevention, which states that, "No two countries
that both have a McDonald's have ever fought a war against each
other." The rationale, according to Friedman, is that when a
country reaches the level of economic development required to support a
McDonald's, people in that country will stop fighting wars for fear
of the resultant economic and personal losses. McDonald's, as a
global foodservice retailer, represents not just a quality standard of
living, but also, in the words of James Cantalupo, president and chief
executive officer of McDonald's International, "a symbol of
something--an economic maturity and [openness] to foreign
investments." (1)

Since then, Friedman's claim, along with the publication of
his popular book, The Lexus and the Olive Tree: Understanding
Globalization, has generated enormous interest and attracted scrutiny.
(2) For the purpose of this essay, if McDonald's is viewed as a
symbol of foreign investment, interesting questions arise regarding the
relationship between foreign direct investment (FDI) and interstate
military conflict. Is it the presence of McDonald's that induces
interstate peace? Or is it the absence of interstate military violence
that leads to McDonald's investment? For Friedman's claim to
be valid, the presence of McDonald's should induce peace rather
than the other way around. But in reality, capital typically evades
violence. (3) Scholars in international relations, business and
economics have concerned themselves with these difficult questions
before, but not to a sufficiently detailed level of analysis.

This essay will examine some key positions, arguments and evidence
in recent academic scholarship on whether foreign investment mitigates
interstate violence, as well as whether interstate conflict deters
investment. Evidence will be offered using new data on bilateral foreign
investment flows and militarized interstate disputes. At a time when
international production--widely viewed as one of the most salient
aspects of globalization--has been increasing in volume and expanding in
scope, many developing countries compete to attract foreign capital, the
relationship between FDI and interstate peace is a timely and
significant topic. (4)

DEFINITION, ATTRIBUTES AND GROWTH OF FOREIGN DIRECT INVESTMENT

A multinational corporation (MNC) organizes production of goods and
services in more than one country, involving the transfer of assets or
intermediate products within the investing enterprise and without any
change in ownership. (5) Foreign direct investment is the purchase of
physical assets or a significant amount of the ownership of a company in
another country to gain a measure of management control. (6) About
three-quarters of International Monetary Fund (IMF) member countries use
the 10 percent rule to define foreign direct investment in data
collection--that is, 10 percent or more of the ordinary shares, voting
power or the equivalent establishes a direct investment relationship.
(7)

Scholarship in international business suggests a widely cited
ownership, localization and internalization (OLI) paradigm to explain
why national firms become transnational. It is said that they do so to
exploit three types of advantages: (1) a firm's ownership
advantages derived from its control over tangible assets such as land or
factory equipment and intangible assets such as product innovations,
management practices, marketing techniques and brand names; (2) the
firm's internalization advantages resulting from its hierarchical
control of cross-border production; and (3) the firm-perceived
location-specific advantages based on the characteristics of host
countries in terms of their economic environment or government policies.
(8)

The nature and logic of FDI define two important, relevant
attributes: the ex post illiquid nature of investment and cross border
jurisdiction. The former refers to the fact that FDI does not move
easily--certainly much less than financial capital such as stocks and
bonds--because foreign direct investors tend to adopt a long time
horizon and build factories and facilities that do not translate into
liquid assets easily. The latter attribute is almost self-evident, for
direct investment flows out of the home economy to enter the foreign
host economy, thus involving the laws and regulations of both countries.
These two attributes determine that foreign investors have an inherent
interest in the relationship between the home and host countries.

Statistics indicate the growing importance of FDI and the economic
power of MNCs in host economies. According to the 2000 World Investment
Report, the number of transnational corporation parent firms has reached
63,000, associated with 690,000 foreign affiliates. (9) International
production has increased faster than global GDP and global exports as
the sales of foreign affiliates worldwide rose from US$3 trillion in
1980 to US$14 trillion in 1999 and are now twice as high as global
exports. Gross product from international production is one-tenth of
global GDP. World FDI inflows amounted to US$865 billion in 1999--about
14 percent of global gross domestic capital formation--relative to 2
percent 20 years ago. (10)

The current strong increase in FDI remains a steady trend, with
investments dispersed among all developed and most developing economies.
The number of foreign affiliates located in developing economies has
reached nearly 130,000. (11) According to the 2006 World Investment
Report, FDI inflows to developed countries in 2005 increased by 37
percent, or US$542 billion, relative to the 2004 level, while developing
countries received US$334 billion--the highest level of FDI ever
recorded. (12) The inward FDI stock flows of developing countries ($2.3
trillion) rose from about 13 percent of their GDP in 1980 to about a
third of their GDP in 2002, almost twice the 19 percent for developed
countries. (13)

One may think about this question from two alternate perspectives:
the perspective of the state that controls the financial regulatory
environment and makes decisions about the use of force; and from the
perspective of the investor who makes investment decisions. Foreign
investors operating in an unfamiliar host environment will be concerned
about the issue of cross border jurisdiction. They inevitably care about
the expected return to their investments and the ease of exit if the
security of their property is threatened. Government policies toward FDI
are thus important for foreign investors. Of particular importance are
host policies on expropriation, exchange control, breach of contract,
repatriation of profits, voluntary divestment, performance requirement,
taxation and other relevant regulations. (14) To the extent that
political violence influences these government policies, foreign
investors will take political violence into account when they make
decisions on the investment location and amount. (15)

From the perspective of the state, it seems intuitive that when two
states fight with each other, both have an incentive to increase their
own chance of winning. As FDI becomes more valuable to many host
economies, so have the security externalities. Foreign Direct Investment
brings to the host economy needed capital and managerial know-how and
creates technology spillovers, helping to promote host economic growth.
Outward investment to a belligerent host country may be subject to both
home and host government restrictions. Home governments are more likely
to encourage FDI to go to their military allies. Politicians engaged in
financially and politically costly military warfare often have an
incentive to impose capital controls and prevent capital flight. The
need to finance expensive wars often requires higher tax rates.

In addition, market-seeking FDI often produce goods aimed for sale
within the host market. In the event of interstate conflict, nationalist
sentiments are likely to run high. Consumers in the host country may be
reluctant to purchase goods and services that are produced by the
foreign affiliates of an MNC headquartered in a belligerent country.
Finally, interstate conflict often interferes with transportation,
communication and the smooth functioning of the market, resulting in
delays in the delivery of goods or unexpected damages. This has an
impact on the trade-dependent vertically integrated FDI, where the
affiliate operating in the host country is just one link within an
MNC's global value chain. Conflict is likely to disrupt the smooth
operation of vertically integrated FDI.

International business scholars have paid much attention to
aggregate indicators of political risk or stability in which interstate
conflict is sometimes one component. (16) For example, Friedrich
Schneider and Bruno S. Frey find that political instability has a
negative effect on FDI flows. (17) In a cross sectional analysis of FDI
flows to thirty-six countries for 1977 and 1982, David Loree and Stephen
Guisinger find that political stability significantly promoted FDI
inflows in 1982, but not in 1977. (18) Using data for all reported
manufacturing plant openings from 1984 to 1987, Douglas Woodward and
Robert Rolfe find that political stability increases the probability of
a country being selected as an investment location. (19) However, Kamal
Fatehi-Sedeh and Hossein Safizadeh fail to find statistical association
between political stability and FDI. (20) Kingsley Olibe and D. Larry
Crumbley do not find consistent evidence that political risk indexes
influence U.S. FDI flows to ten out of thirteen Organization of
Petroleum Exporting Countries (OPEC) countries. (21) Deepak Sethi, S.E.
Guisinger, S.E. Phelan and D.H. Berg find that political instability,
measured by a composite variable on a hundred-point scale, did not
influence U.S. FDI flows to twenty-eight countries from 1981 to 2000.
(22) Stephen Globerman and Daniel Shapiro conduct a two stage analysis
of U.S. FDI flows to 143 countries from 1994 to 1997, in which the first
stage investigates the causal factors of the probability that a country
is an FDI recipient, while the second stage examines the determinants of
the amount of FDI received. Using an index of political instability and
violence, including armed conflict, social unrest, terrorist threats,
etc., they find that these indicators do not influence the probability
of whether a country receives any FDI inflow, but reduces the amount of
FDI inflow a country receives. (23) That is, the average size of an FDI
transaction may change independently of the probability of a country
receiving the FDI. The econometric evidence is obviously mixed and
inconsistent across studies.

In an exceptional analysis, Douglas Nigh emphasizes the need to
separate conflict and cooperation and to distinguish interstate and
intrastate factors. (24) Nigh argues that the political aspect of an
investment environment is driven by the subjective perception of
investors from the home country. (25) Host countries could have the same
democratic level of development, but investors could subjectively choose
one country over another because of a historical relationship or
contemporaneous events within the host nation. Moreover, since
"U.S. investors realize that many host country officials and
citizens do not distinguish between the interests of the U.S. government
and those of U.S. direct foreign investors, even if the two are usually
carefully differentiated by the U.S. political process," investors
have to take into account politico-economic relations between two
nations. (26) Therefore, investors watch closely for the possible
international and intranational cooperation or conflict that provide
invaluable information about the business environment in a particular
host country for an investor from a particular home country In his
statistical analysis of manufacturing FDI by U.S. firms to twenty-four
countries over twenty-one years, Nigh finds that international and
intranational conflicts reduce U.S. investment while international and
intranational cooperation increases it. (27)

In a recent study, I addressed the puzzling contradictory findings
on political risk, offering a new analysis with several innovations. My
theory considered how rational expectations and uncertainty on the part
of foreign investors investors influence the ways in which political
violence, including interstate and intrastate conflicts and
transnational terrorism, changes investment behaviors. (28) According to
this theory, foreign investors are forward-looking, constantly
anticipating how political violence affects both the expected returns of
their investments and the political barrier to exit. They frequently
assess the probability of political violence and the likelihood that
such occurrences might induce hostile policy changes. When firms
internalize these risk assessments into their investment decisions, a
high risk of political violence will deter future investment flows and
may lead to divestment from existing projects. These changes in
investment decisions are based on expected risks and, therefore, often
occur before the events of political violence materialize. One
implication is that ex post, many actual events of political violence do
not produce behavioral changes in investment.

But this is not the whole story. Because investors do not have
perfect foresight, they cannot fully anticipate all the occurrences of
political violence or accurately assess the level of the risk involved.
This forces investors to adjust their investment decisions ex post when
they experience unanticipated political violence. The reason is simple.
Unanticipated occurrences of political violence often lead to
unanticipated hostile policy changes (e.g. expropriations), causing the
expected returns of an investment project to decline. In the absence of
perfect foresight, the ex ante and ex post risk-adjusted returns will
not be identical. Hence, unanticipated incidents of political violence
carry new information and compel investors to moderate their ex ante
optimism. Consequently, it is conceivable that even without an actual
unfavorable policy change, investors may expect such a policy change to
be forthcoming, thus choosing to divest, reduce or stop future
investments altogether.

I further separate different types of political violence into civil
war, interstate war and transnational terrorism and conducted a country
level statistical analysis of 129 countries from 1976 to 1996. (29) With
respect to interstate war, anticipated conflict does not affect the
chance that a country is selected as an investment destination or the
amount of FDI inflows a country receives. However, unanticipated
interstate war reduces a country's chance to be chosen as an
investment location, though it has little effect on the amount of FDI a
country receives. These results suggest that interstate war largely
deters new equity investment flows into a country. (30)

In a recent study, Glen Biglaiser and Karl DeRouen argue that U.S.
troops stationed in host countries signal positive relations and
possible alliances between the United States and host countries,
indicating investment stability that is only available to U.S. firms.
Through statistical analysis of 126 developing countries between 1966
and 2002, they find that the presence of U.S. troops encourages U.S.
capital inflows. (31)

DOES FDI INFLUENCE MILITARY CONFLICT?

If one follows the convention of treating FDI as one of the most
salient aspects of integration into the global economy, then answers to
this question are more contentious, involving such familiar schools of
thought as realism, Marxism/dependency theory and liberalism. The
realist position considers economic forces as operating in the realm of
low politics--not supposedly higher realms like diplomacy or war. To
realists, "the most important events in international politics are
explained by differences in the capabilities of states, not by economic
forces operating across states or transcending them." (32) If
globalization matters at all, it serves to threaten political stability
in international politics because the loss of economic policy autonomy
spills over into the foreign policy area. (33)

Dependency theory emphasizes international trade and investment as
the mechanisms through which the international capitalist order distorts
the economies of developing countries. (34) Reliance on foreign capital
perpetuates the low status of developing countries in the hierarchy of
the world system, which will cause conflicts between the core and the
periphery. As evidence of this phenomenon, theorists often point to many
instances of the nationalization of foreign investment in various
countries in early stages of their development. (35) More recent
expropriations also appear to confirm FDI to be a source of interstate
conflict. For example, Namibia initiated land reform in 2004 to
redistribute land from white farmers of German origin to black landless people. By November 2005, the government had issued expropriation orders
to eighteen white commercial farmers and had said the land would be
given to almost 250,000 landless people. (36) In April 2006, Venezuelan
president Hugo Chavez seized two oil fields from two foreign oil
firms--France's Total and Italy's Eni--because both firms
failed to reach an agreement with the Venezuela government on new
joint-venture contracts that would give a majority stake to the
state-owned company, Petroleos de Venezuela. (37) On 1 May 2006,
Bolivian president Evo Morales decreed the nationalization of the
country's natural gas industry and ordered the military to occupy
the natural gas fields and all companies to turn their production over
to the state's Yacimientos Petroliferos Fiscales Bolivianos. (38)

Adherents of liberalism argue that economic linkages created
through free international markets make war more costly, thus reducing
the incentive for war. (39) Cumulative statistical evidence appears to
favor the liberal notion that trade interdependence is associated with
peace. (40) In the context of FDI, Richard Rosecrance and Peter Thompson
suggest that FDI represents a link that is costly and time-consuming to
break due to its illiquid nature. Thus, FDI is more likely to reduce
conflict than trade. (41) Looking at data on U.S. FDI and conflict with
other countries between 1950 and 1992, they find that FDI reduces
conflict and that two-way FDI has a stronger impact than one-way FDI.

Criticizing both the narrow focus on trade and the underlying
theory of liberalism, Erik Gartzke, Quan Li and Charles Boehmer study
why and how FDI--among other things--affects interstate military
conflict. (42) They argue that the liberal opportunity cost argument is
logically inconsistent with the bargaining theory of war. The game
theory literature of international conflict posits that the decision to
go to war results from the failure of bargaining between states because
states are uncertain about their opponent's payoff structure and
resolve over a contested issue. States sometimes fight to demonstrate
capability or resolve. Economic integration, measured in terms of trade,
FDI and financial openness, reduces the probability of war by serving as
a means of costly signaling, rather than by changing the cost-benefit
calculus. On one hand, when both parties already know the value of their
economic exchange before engaging in military action, the size of the
economic stake per se provides no information about the resolve of the
contestant. On the other hand, when a military threat over the contested
issue drives away international production capital, the economic price
the state is willing to pay gives the state's threat additional
credibility. Such costly signaling informs the other state of its
opponent's resolve, often resulting in bargaining success and
avoidance of violence. Statistical analyses confirm that globalization
indicators including FDI reduce interstate militarized disputes between
countries.

Focusing on how international production affects international
security, Stephen Brooks presents three causal channels. (43) First, the
geographic dispersion of international production reduces the economic
benefits of military conquest, particularly among the advanced
countries. Military conquest threatens foreign capital, often reducing
the spoil for the conqueror along the dispersed value chain and
decreases technological innovation in knowledge-based economies. Brooks
demonstrates how Soviet rule in Hungary prevented the country's
policy efforts from producing any significant amount of FDI inflow
before 1990, bringing about little economic benefit to the Soviet Union
itself. (44)

Second, competition for global production capital deepens regional
economic integration among long-standing security rivals, producing
better political relations with some qualifications. That is, members of
regional trade agreements have to be few in number and have large
economies; forcing them to cooperate to attract foreign capital. Brooks
cites how the development of the Southern Cone Common Market (MERCOSUR),
motivated partly by the pursuit of foreign capital, helped Argentina and
Brazil to resolve their 150-year-long security rivalry. (45)

Third, states pursuing cutting-edge military technology can no
longer resort to autarkic defense production. The involvement of MNCs in
the defense industry leads to the internationalization of weapons
production and the rising cost, complexity and scale of developing new
military technologies. The internationalization of U.S. defense
production and military technology stood in sharp contrast with the
autarkic production of the Soviet Union, which contributed to a
technological gap. (46)

Brooks attributes the postwar peaceful relations among great powers
to the dispersion of international production, but argues that the
dispersion of international production capital has not produced such
pacifying effects on security relations among developing countries and
has had only a mixed effect on security relations between great powers
and developing countries. (47) This is mainly because the noted economic
and institutional conditions under which international production
reduces the economic benefits of military conquest and deepens regional
integration among security rivals are not present in developing
countries. Furthermore, since developing countries most often employ
their militaries in regional actions and focus on less complicated,
smaller weapons systems, it is unlikely that the globalization of
defense-related production would be relevant to their security
relations.

NEW EVIDENCE ON BILATERAL FDI AND INTERSTATE MILITARY CONFLICT

There is little direct evidence that links bilateral FDI with
interstate military conflict. Almost all studies focus on FDI inflows at
the country level or bilateral outflows to others from only the United
States. It seems imperative that empirical inquiry be expanded. Here,
two factors are examined: bilateral FDI flows and dyadic military
conflict (conflict between two nations), using relatively more
comprehensive data. The data used for this study tracks FDI flows among
twenty-nine OECD countries, as well as between those countries and
twenty-nine non-OECD countries, from 1980 to 2003. (48) There is no
coverage of FDI flows among non-OECD countries. Still, this is by far
the most comprehensive bilateral FDI data currently available. For
dyadic conflict, we use the widely used and recently updated Militarized
Interstate Dispute (MID) data. An MID is a conflict in which one or more
states engages in a threat of military force, display of force, use of
force or war against one or more other states between the years 1816 and
2001. (49)

[FIGURE 1 OMITTED]

Average FDI flows from one country to the other can be computed and
compared between the dyad in peace and the dyad in MID or military
conflict. Such a comparison allows us to observe whether the two types
of dyads differ systematically in terms of foreign investment. Figure 1
illustrates this comparison. The dyad in peace witnesses an average of
410 million constant U.S. dollars worth of FDI flowing from the source
to the recipient country. In contrast, the dyad in conflict observes an
average of 250 million constant U.S. dollars worth of FDI flowing from
the source to the recipient, which is nearly 40 percent less than the
level for the dyad in peace. While this evidence does not indicate
whether it is peace that induces more FDI or that it is more FDI that
curtails conflict, it is rather obvious that peace and conflict go hand
in hand with differing amounts of investment.

Economies differ in size and level of development. Average
bilateral FDI flows tend to be heavily influenced by outliers and do not
accurately gauge the relative significance of bilateral FDI flows to
recipient and source economies. One way to circumvent this problem is to
measure the relative importance of bilateral FDI flow to an economy by
looking at the percent ratio of the FDI flow over the GDP of the
recipient or the source. Figure 2 compares the average FDI/GDP percent
ratio between the dyad in peace and that in conflict. For the recipient,
the FDI/GDP ratio is 0.014 percent in the conflict dyad and 0.084
percent in the peace dyad. There is little doubt that this 83 percent
difference is enormous. One may interpret this evidence as demonstrating
either that the bilateral FDI recipient suffers a huge loss in foreign
capital inflow due to its involvement in military conflict, or that a
low level of FDI inflow tends to increase the probability of conflict
between the recipient and the source or that both channels work
simultaneously.

[FIGURE 2 OMITTED]

Interestingly, for the source country, the FDI/GDP ratio is 0.47
percent versus 0.84 percent between the conflict and peace dyads. This
is still a large difference, although not as dramatic as that for the
recipient country case. Likewise, one may interpret this as being
produced by one of the three possible causes: the source of bilateral
FDI invests much less in the recipient with whom it has a military
dispute; too little investment from the source to the recipient tends to
increase the likelihood it will fight militarily with the recipient; or
both.

Evidence from Figures 1 and 2 indicates that bilateral FDI flows
and dyadic military conflict are negatively correlated. This pattern
contradicts both the realist position that these two phenomena are
unrelated, and the dependency position that more FDI flows tend to beget more military conflict. This evidence also appears to support the
liberal position and Friedman's Golden Arches Theory that FDI leads
to peace. The difficulty with this inference favorable to the liberal
position, though, is as noted above: one simply can not rule out the
possibility that conflict reduces investment--not the other way around.

[FIGURE 3 OMITTED]

Is it possible to disentangle the issue of causation between
bilateral FDI flow and dyadic military conflict? Without complicating
this essay with technicalities, one may get a glimpse of the
relationship by looking at the changes in bilateral FDI flows over time.
Figure 3 illustrates the temporal changes for average bilateral FDI
flows in millions of constant U.S. dollars. For dyads in peace,
bilateral FDI flows tend to be stable across the current year (t), the
year before (t-1) and the year after (t+1). In contrast, for dyads that
are involved in conflict, the graph shows interesting temporal changes.
It is worth noting that for both the FDI and source-GDP and the FDI and
recipient-GDP series, the same temporal patterns emerge. In the year
before conflict occurs, FDI flows are already quite low when compared
with those of the same period in the peace dyad. In the year of conflict
occurrence, the amount of flows only declines slightly from the year
before. In the year after conflict occurrence, investment resurrects and
climbs up to almost the same level as in the peace dyad. The evidence
supports the rationalist explanation that investors are forward looking
and--at times--anticipate conflict correctly and do not invest in
conflict areas before conflict occurs. The ex ante investment decline is
followed by only a small drop in the conflict year because investors
guess right often enough, or because they do not always correctly
anticipate conflict occurrence. In the post-conflict year, investors
reevaluate the situation and, in light of the new information revealed
by the dispute, anticipate less conflict for the future. This
demonstrates much about how conflict or the expectation of conflict
influences investment decisions, but the new evidence does not reveal
much about whether investment reduces conflict--a possibility that also
cannot be ruled out.

CONCLUSION

The evidence demonstrates that bilateral FDI flows and dyadic
militarized disputes are negatively correlated. This contradicts the
realist position and the dependency theory on how integration into the
global economy influences peace. It is consistent with the liberal
expectation and Friedman's Golden Arches Theory, but the underlying
mechanism of liberalism is incompatible with the bargaining theory of
war. The signaling argument is consistent with the bargaining theory of
war, but it does not fully consider the suppressive effect of conflict
on investment. A rationalist explanation of how conflict affects
investment appears linked to temporal patterns of investment over time.
It remains unclear how this fits with the signaling argument of how
investment influences conflict.

(4) Economic globalization is most often defined as the integration
of financial markets and the global dispersion of production capital.
See Michael Veseth, Selling Globalization: The Myth of the Global
Economy (Boulder: Lynne Rienner, 1998); Jagdish Bhagwati, In Defense of
Globalization (New York: Oxford University Press, 2004).

(12) United Nations Conference on Trade and Development (UNCTAD),
"World Investment Report 2006: FDI from Developing and Transition
Economies: Implications for Development," (United Nations, New York
and Geneva, 2006), xvii.

(14) For a discussion of the policy types, see note 4. Thomas L.
Brewer, "Government Policies, Market Imperfections, and Foreign
Direct Investment," Journal of International Business Studies 24,
no. 1 (1993), 101-120. One may argue that a multi-national enterprise
(MNE) may not necessarily care too much about the risks for particular
investment asset, since the firm can diversify away some of the risks by
holding a market portfolio (Butler and Joaquin (1998), 600). For
specific investment asset in a particular country, at least part of the
political risks resulting from political violence-related policy changes
are not diversifiable risks. This is because investors cannot fully
anticipate all contingencies and because the market for the
securitization of political risks is not yet well developed; John
Finnerty, "Securitizing Political Risk Insurance: Lessons From Past
Securitization" in International Political Risk Management, ed.
Theodore Moran, (Washington: World Bank Group, 2001). See also Kirt
Butler and Domingo C. Joaquin, "A Note on Political Risk and the
Required Return on Foreign Direct Investment," Journal of
International Business Studies 29 (1998), 599-607.

(24) Douglas Nigh, "The Effect of Political Events on United
States Direct Foreign Investment: A Pooled Time-Series Cross-Sectional
Analysis," Journal of International Business Studies 16 (1985),
1-17.

(48) "International Direct Investment Statistics Yearbook,
1992/2003," Organisation for Economic Cooperation and Development
(2004). The basis for this statistic is balance of payments data
published by central banks or statistical offices of the corresponding
countries.